Fair Value, the Financial Crisis, and Some Nice Distinctions By Laux and Leuz

Christian Leuz emailed me with a link to his recent paper with Christian Laux, entitled “Did Fair-Value Accounting Contribute to the Financial Crisis.” He thought it might be of interest to our readership, and having spent some time with the paper this morning, he is right. In short, the paper’s answer is “no,” which is consistent with the SEC’s Study on Mark-To-Market Accounting. The paper is not a full-throated endorsement of Fair Value — it is far more positive than normative, and notes that banks may have used the leeway of FV measurement to overvalue assets (rather than undervalue them).

I have not spent enough time with the paper to assess the validity of their calculations. But I like some of the distinctions the authors make, which are all too often forgotten in debates about FV.

The paper begins by addressing concerns about destabilization, and remarks:

Furthermore, downward spirals can arise because contracts (e.g., margin and collateral requirements, haircuts) are based on market values or because banks use market values to manage their business (e.g., Value at Risk techniques). It is easy to confuse problems that stem from using market prices in private arrangements with problems from using market values in accounting. Thus, it is important to be specific about the links through which write-downs under fair-value accounting can create problems, be it capital regulation, contracts, a fixation on accounting numbers by managers or investors, or inefficient markets. [My emphasis]

Hear, hear! Critics of fair value need to be clear on the mechanism by which it causes problems. To the extent the mechanism is through banking regulation, the solution is more likely to be decoupling of regulatory accounting from GAAP accounting. And to the extent it is ‘fixation,’ efficient market theorists have some explaining to do. (I should point out that the paper does a very nice job of discussing banking regulations, so this makes a good primer for non-banking experts).

Laux and Leuz also distinguish clearly between assets and inputs. All too often, people refer to “level 1 assets” and “level 3 assets,” thinking that level 1 assets are those for which there is an observable market price for identical assets, and level 3 assets are those for which management must use their own estimates of value (“mark-to-model”). Not quite. Instead, management can use level 1 inputs to measure the fair value of an asset (by looking at market prices for identical assets) or can use level 2 or 3 inputs (similar assets or internal models) to measure the fair value.

This is important in understanding the role of fair value measurement in the financial crisis, for, as the authors point out,

Fair-value accounting as stipulated by the FASB has several safeguards against marking to potentially distorted market prices and hence against accounting-induced downward spirals and contagion.

First, the rule explicitly states that prices from a forced liquidation or distress sale should not be used in determining fair value. Thus, if fire sales occur, banks should not mark their assets to these prices, which amounts to a “circuit breaker” in the downward spiral. In practice, it can of course be difficult to identify prices that stem from fire sales but the rule gives banks a legitimate reason to discard certain prices.

…

Third, as markets become inactive, FAS 157 explicitly allows banks to use valuation models to derive fair values. That is, banks are not forced to use dealer quotes that are distorted by illiquidity. As the financial crisis deepened, banks used this option. Of all the assets reported at fair value in the first quarter of 2007, bank holding companies used Level 1 inputs (quoted prices) for 34 percent of them; by the first quarter of 2009, this fraction decreased to only 19 percent. For bank holding companies, most of the decline in Level 1 assets appears to be compensated by an increase in Level 2 assets, although Level 3 assets increase from about 9 to 13 percent (Table 3). For investment banks, Level 3 assets also increase to 14 percent, mirroring a decrease in Level 1 assets from 27 to 22 percent.

Keep in mind that these are the same assets, but the banks are choosing whether to use level 1 or level 3 inputs, as the level 1 inputs become tainted by illiquidity (disorderly transactions).

One minor quibble: if I had my way, the authors would replace all uses of the term ‘fair value accounting’ with ‘fair value measurement.’ I know that the first term is more common, and even the FASB uses it. But fair value accounting suggests that any number of things might be changing. But the only issue here is how assets are measured, not whether assets and liabilities are being recognized or derecognized, but how they are measured. For example, we often hear concerns like “fair value accounting will allow firms to recognize profit on products they have just begun designing, because their internal models indicate it is a positive NPV project.” Not true — fair value standards govern only the measurement of assets that have already been recognized, and I don’t see much chance that we will be recognizing assets for products in the design phase.

Robert Bloomfield

Robert Bloomfield is the Nicholas H. Noyes Professor of Management and Accounting at the Johnson Graduate School of Management at Cornell University, where he has taught and conducted experimental research since 1991.

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6 comments on “Fair Value, the Financial Crisis, and Some Nice Distinctions By Laux and Leuz”

Thanks Rob. Looks like a very useful paper. Could be fodder for a round table.

As for your quibble, I am curious how your definition of “fair value accounting” differs from “fair value measurement.” If one defines the former as “net recognized assets of the company must equal market capitalization at each reporting period,” then I agree that the two are VERY different. Otherwise, the difference is somewhat hazy for me. For example, current accounting allows recognition of inventory and patents as assets. Fair value measurement (other than possible impairment) is currently not applied to these two types of assets. But if it were, then profit recognition could occur earlier than under current practice approaches simply by changing the measurement basis for inventory and patents.

One way to think about this is that over the life of a transaction/activity/project, fair value and historical cost measurement should produce similar measures of performance (e.g., income or cash flows). Initial recognition under both approaches generally occurs at fair value (e.g., buying a piece of inventory), and the proceeds received in subsequent transactions (e.g, selling a piece of inventory) are recorded at fair value (eventually). The real difference in that fair value measurement recognizes profit or loss for a specific transaction/activity whenever evidence exists that fair value has changed, which is likely to be almost continuous. Under historical cost, recognition is either based on a transaction being consumated or on some allocation of past transaction amounts over time (e.g.depreciation).

This differential timing opens the door for profits to be recognized earlier if fair value measurement is applied. While quite a few people are willing to consider fair value for financial instruments (which are the assets being considered in Laux and Leuz), a lot of folks (including me, most FASB members I have talked to, and the folks you mention in your quibble) get very uneasy when one starts applying fair value measurement to operating assets.

If I understood Rob correctly, he would change your last sentence to say they “get very uneasy when one starts applying fair value accounting to operating assets.”

With our current impairment models, we already use fair value measurements for operating assets on occasion. But those are one-off measurements that do not change the primary means of accounting for the assets.

Disclaimer: The views expressed here are my own and do not represent positions of the Financial Accounting Standards Board. Positions of the FASB are arrived at only after extensive due process and deliberations.

@Bob, it seems like some people actually would define fair value accounting as you did: “net recognized assets of the company must equal market capitalization at each reporting period.” But that is a characature, not being seriously proposed by anyone.

But internally-generated R&D and marketing get at the distinction I am making: the term fair value measurement makes it clear that it doesn’t in any way force recognizing an asset for those expenditures.

Fair value measurement differs from other measurement methods in both the timing of asset remeasurement, and the number you could come up with.

So thanks for the comment, which clarifies that while we shouldn’t lump together FV accounting and FV measurement, we also shouldn’t lump together the timing and value aspects of remeasurement.

I have been advocating the decoupling of regulatory accounting from GAAP to relieve concerns that regulators (not banks) seem to have about fair value measurements. If they don’t like the measures, they don’t have to use them for regulatory measures. I wrote a Compliance Week column on that point not too long ago. I’m happy to see that after the adoption of FAS 166/167 by the FASB, the US bank regulators put out a press release indicating their intention to re-look at their capital rules. In the past, they’d have called for FASB to withdraw its guidance, so I took this as a positive change.

Thanks for the comment. For those interest in more, I suspect this is the article Scott is referring to:

Accounting Is for Investors

Many institutions and companies continue to say that securitizations must achieve off-balance sheet accounting to get the credit markets flowing again. Historically, bank regulators, because they looked to GAAP measures in regulatory calculations, effectively added pressure to FASB to facilitate off-balance sheet accounting, and GAAP had been specifically crafted in response to these pressures. In fact, the QSPE was introduced to ensure that the certain kinds of securitizations could be off balance sheet. And the permitted uses of QSPEs expanded, officially and unofficially, over the years to provide off-balance sheet treatment to more and more transactions. The lenient accounting encouraged transactions that led to the crash of the mortgage-backed securities markets.

In almost every instance, users of financial statements disagreed with the continued facilitation of derecognition, and the transactions were often “reversed” by credit analysts and others. FAS 166 and 167 show that FASB has listened to financial statements users and resisted the pressure to continue to provide an accounting motivation for securitizations.

In addition, bank regulators seem to have retreated from pressuring FASB to change GAAP to achieve regulatory goals. The Federal Reserve has noted that it is reviewing regulatory capital requirements in response to the new standards. That’s good news. If the standards are in investors’ best interests, they should stand. If those same standards don’t work for regulatory purposes, the regulators should adjust as necessary.

I can only hope that companies follow this lead by accepting and dealing with the new standards, rather than fighting them for reasons having nothing to do with effective financial reporting.

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